Experts search for method to Apple's Beat madness

Analysts today struggled to explain why Apple might acquire Beats Electronics, the headphone maker and music subscription service operator, for $3.2 billion, as several reports claimed.

If nothing else, the diversity of expert opinion illustrated the difficulty in analyzing the famously secretive company, the several plays Apple might make with Beats' assets, and the inherent interest in a deal of such magnitude by the typically miserly firm.

"This would be the biggest deal ever by Apple, the first significant acquisition by [CEO] Tim Cook, and the first where Apple would likely want to keep the brand going, rather than absorb it," said Jan Dawson, chief analyst at Jackdaw, outlining some of the reasons the reports have struck a nerve among Apple observers.

Some analysts believe Apple wanted the trendy but expensive headphones Beats sells, others saw Beats Music, the $10-per-month music service that launched earlier this year, as the plum. Still others thought Apple is eyeing a two-fer that would immediately help a pair of revenue streams climb out of stagnation.

The deal was first reported Thursday by the Financial Times (subscription required), with other outlets quickly following, including the New York Times, Reuters and the Wall Street Journal. All cited anonymous sources, and said that while nothing has yet been inked, an announcement would likely be made very soon.

"I think Apple is primarily a hardware company and services are just a moat to increase customer loyalty," said Sameer Singh, an independent analyst who covers mobile technology at his Tech-Thoughts website. Singh was one of those who saw the deal's origins in Apple's attraction to Beats headphones, which cost hundreds and reportedly have huge profit margins. If that sounds familiar, it should: Apple uses the same model for many of its products, which command premium prices.

The bulk of Beats' revenue -- estimated at around $1 billion last year -- reportedly stemmed from its headphone sales.

"The headphones would be nice to have, but they're not the reason for this deal," said Sinnreich. "This is part of the transition Apple must make to create stronger service relationships with its customers."

To Sinnreich, acquiring Beats makes sense only if Beats Music, the subscription service that debuted in January, is the primary reason Apple put billions on the table.

"It's very clear from the market that the music download business is stagnating and failing," said Sinnreich. "So it comes down to whether Apple wanted to build versus buy" a streaming service of its own.

Music subscription services, particularly Spotify, have eroded download sales as consumers increasingly switch to a rental model that gives them on-demand access to millions of tracks. Although Apple kicked off iTunes Radio last year, a free, ad-supported service that competes more directly with Pandora, it has received mixed reviews and gotten little traction among listeners.

Sinnreich believes that Apple thought it needed a subscription service faster than it could build one, and so went shopping. While it was unclear whether rights that Beats Music has acquired with record labels would transfer -- Sinnreich assumed they would if Apple's willing to put up $3.2 billion, others said Apple would have to renegotiate streaming rights -- Sinnreich pointed out that there is more to Beats Music than meets the eye.

Its human-curated playlists have been applauded by critics, but Sinnreich focused on the underlying technology that also recommends tunes as something Apple would want to bolster its own iTunes Radio. Perhaps that technology could also be applied to a Netflix-like movie- and TV-streaming service, Sinnreich said.

"And this goes hand-in-glove with the Shazam arrangement," said Sinnreich, referring to reports last month that Apple would integrate song identification technology created by Shazam into the next version of iOS. With the talent behind Beats under its control -- renowned music producer Jimmy Iovine and rapper Dr. Dre -- and the Beats Music algorithms, Apple would have even more opportunities to discover new artists and connect them directly to listeners, cutting out the recording label middlemen.

"That's a very compelling prospect for Apple," Sinnreich asserted, an advantage over digital music rivals and one worthy of spending billions to keep customers locked into the iPhone ecosystem. "Something has to change. Apple's fortunes can't reside on charging 30% more for hardware. It needs a much broader strategy that's about conquering new markets and creating new modes of consumer engagement."

Wait a minute: Both Singh and Sinnreich are off-base, said Dawson, who contended that it isn't an either-or proposition -- headphones or subscription service -- but that Beats is attractive to Apple because it could help with two of the Cupertino, Calif. company's struggling revenue streams.

"Two parts of Apple's business would benefit from adding Beats, accessories and iTunes content," Dawson said in an interview today. "Beats is now a significant business in headphones, which would add about 25% [more revenue] to Apple's accessories line. And Apple badly needs a streaming subscription music service to compete with Spotify, which has most of the action."

In a post to his research firm's website, Dawson elaborated on his premise, illustrating how both music download sales and accessories revenue are in decline and stagnant, respectively. Each of those components account for about 4% of Apple's total revenue, so while the $3.2 billion may seem excessive, if Beats can help Apple boost sales of 8% of the company, the money would be well spent.

"Given that core hardware growth is slowing too, creating greater leverage around the hardware revenue base -- by increasing sales of related items such as content and accessories -- is a smart way to keep revenue growth going, at least until a new hardware category emerges," Dawson wrote, referring to pressure from Wall Street for Apple to come up with another big hit.

"The strategic rationale behind this would be to expand accessories and getting music going again," said Dawson in today's interview. "Beats Music's curation and recommendation technology could help iTunes in general -- iTunes Radio specifically -- but discovery is a huge trend. Content of any kind must have effective curation, discovery and recommendation."

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